The Bigger Story?

A bigger story than what's happening in the stock market this week may be what's happening in the world's bond markets. We may have finally hit a turning point in investors' appetite for risk. From Bloomberg:

Bond Risk Soars by Record in Europe, Credit-Default Swaps Show

Feb. 28 (Bloomberg) -- The risk of European corporate bonds from carmaker Fiat SpA to music producer EMI Group Plc surged by a record, fanning a global market rout, according to traders of credit-default swaps.

...Investors are concerned rising delinquencies on the riskiest mortgages in the U.S. may spread to other parts of the home-loan market, hurting consumer confidence. Bank of America Corp. yesterday recommended investors sell corporate bonds as "housing-led weakness" spreads to the broader debt market.

As the following chart shows, investors have been willing to accept an increasingly small risk premium (which I've measured here as the difference between the interest rate on US corporate bonds of varying quality compared to the interest rate on US government bonds) over the past few years. But those risk premia have now reached a level that is historically about as small as we've seen, at least in recent history.


(Click on image for better view. Btw - I'm pretty grumpy that blogger has started messing with my images...)

The risk premium generally follows the business cycle (as Spencer pointed out in the comments yesterday). It may be the case that we've now hit bottom, and we may eventually remember this week as the week that risk premia started rising again.

A Superlative Day

Taking a look at the top headlines from Bloomberg, we find that it's a superlative day:

• Stocks in US Drop Most Since 2002 as Chinese Market Rout Sparks Selloff
  
  
• Treasuries Post Biggest Gain Since June 2005 as Investors Seek Safest Debt
  
  
• Yen Rises Most Since 2005 as Traders Unwind Bets Against Japan's Currency
  
  
• Corporate Bond Risk Increases Most in 18 Months

Here's the picture of the day: today's action in the S&P 500 index.



Apparently there's a bit of nervousness out there in some parts of the financial world...

Tightening Credit Standards

Speaking of tightening credit standards...

Freddie Mac to Tighten Subprime Rules

Freddie Mac will stop buying subprime mortgages with "a high likelihood of excessive payment shock and possible foreclosure" as part of new investment requirements that will be implemented on Sept. 1, the company announced.

The government-chartered loan clearinghouse said it will only buy subprime adjustable-rate mortgages, and mortgage-related securities backed by those loans, that qualify borrowers at the fully-indexed and fully-amortizing rate. Freddie said, "The goal is to protect future borrowers from the payment shock that could occur when their adjustable-rate mortgages increase."

"Some of these products that worked in the past don't work going forward," Chairman and Chief Executive Richard F. Syron said in an interview with CNBC.

As I discussed yesterday, while this phenomenon can indeed help push the housing market further down, the bigger danger to the US economy is that credit standards may soon be tightened more generally, not just to home-buyers, leading to a fall in lending and investment across the economy.

More and more often when I read the business news these days, I feel like I'm back in the year 1990. It all seems very familiar, and it doesn't cheer me up that it's also utterly unsurprising.

Housing Drag

The housing market downturn is putting a drag on the US economy. There's little doubt about that, as noted earlier today. Rich Miller and Matthew Benjamin have a fairly good discussion about the issue today in a piece on Bloomberg.com:

Housing Slump May Force Fed to Pare Annual U.S. Growth Estimate

Feb. 26 (Bloomberg) -- The U.S. may be saddled with more sluggish growth than the Federal Reserve expects as the economy struggles to shake off a lingering hangover from the housing bubble.

"We're in the midst of a classic boom-bust credit cycle in housing," says Andy Laperriere, managing director at International Strategy & Investment Group in Washington. "And the bust is just beginning."

The worst case: Distress already evident in the riskiest part of the mortgage-lending industry turns into a full-scale credit crunch that cripples the housing market and the economy.

...The financial fallout from the housing slump delivers a one-two punch to the industry and the economy. It increases supply as homeowners with adjustable-rate mortgages can't meet the higher loan payments and are forced out of their houses. Mortgage foreclosures monitored by Irvine, California-based research firm RealtyTrac jumped 19 percent in January.

The credit squeeze also depresses demand as prospective buyers find it more difficult to obtain loans. According to a Fed survey published on Feb. 5, more U.S. banks toughened lending requirements for home loans in the final three months of 2006 than in any quarter since the early 1990s.

...The financial stresses are most evident in the subprime mortgage market for the riskiest borrowers. The segment accounts for 13 percent of the $10 trillion in home loans outstanding, according to Inside Mortgage Finance, a trade publication.

Some 20 percent of the roughly $1.2 trillion in subprime loans made during the past two years will end in foreclosure, with owners losing their homes, says the Center for Responsible Lending in a study. The center, located in Durham, North Carolina, is a nonprofit organization financed by the Ford Foundation and Rockefeller Foundations, among others.

The article does a good job describing the nature of the vicious cycle that the housing market is susceptible to: the end to the run-up in house prices has effects on both supply and demand in the housing market that tend to force prices down further.

But this piece only hints at the ways in which the housing market downturn can be a drag on the broader economy. The direct effect of lower income and fewer jobs in the construction and home improvement industries is quite clear. And the indirect effect of falling house prices on consumer wealth and spending (including the end of the house-as-ATM) has also been written about extensively. But perhaps the biggest potential impact, however, is the effect that a large number of mortgage defaults might have on credit markets more generally in the US economy.

No one seems quite sure of who is holding the bad mortgages (banks, mortgage companies, and insurance companies who hold such assets all claim to have diversified the risk away pretty effectively), but the fact remains that someone in the US economy must suffer a loss on their balance sheet for every mortgage that ends in default. As those lenders (who may either be direct lenders or, more likely, indirect lenders to US borrowers) absorb balance sheet losses, they will have fewer assets to lend out. That means that the amount of loanable funds in the US economy in general will shrink, affecting not just the housing market, but all credit markets in the US. In particular, it's very possible that the volume of business loans will be forced to fall, which would make it harder for businesses to keep investing and providing an impetus to the economy.

In short: It's important to try to understand the dynamics of why the housing market slowdown may be just beginning. But it may turn out to be much more important to understand the impact that this is going to have on the US's credit markets more generally.

Bearish Greenspan?

The AP reports today on an interesting comment by Alan Greenspan:

Greenspan Warns of Likely U.S. Recession

HONG KONG -- Former U.S. Federal Reserve Chairman Alan Greenspan warned Monday that the American economy might slip into recession by year's end.

He said the U.S. economy has been expanding since 2001 and that there are signs the current economic cycle is coming to an end.

"When you get this far away from a recession invariably forces build up for the next recession, and indeed we are beginning to see that sign," Greenspan said via satellite link to a business conference in Hong Kong. "For example in the U.S., profit margins ... have begun to stabilize, which is an early sign we are in the later stages of a cycle."

"While, yes, it is possible we can get a recession in the latter months of 2007, most forecasters are not making that judgment and indeed are projecting forward into 2008 ... with some slowdown," he said.

Greenspan said that while it would be "very precarious" to try to forecast that far into the future, he could not rule out the possibility of a recession late this year.

Okay, there's a bit of a difference between "not ruling out the possibility of a recession" and actually predicting a recession, but it still seems to be a rather darker reading of the US economy than was typical for Greenspan while he was Fed chair.

The thing is, his points make a fair bit of sense, and I suspect that he might be right on this one.

Income Inequality: The Inconvenient Truth II

Don't miss Mark Thoma's latest installment in the debate about income inequality over at Cato Unbound. I think Mark makes a particularly excellent analogy when he equates the "debate" over rising income inequality with the "debate" over global warming:

This debate reminds me of the debate over global warming, though using the word "debate" implies there is more disagreement than there really is. There are three questions in the global warming debate. The first question is whether global warming exists. The second question is, if it does exist, what is causing it. The third question is what to do about it. In order to avoid the consequences involved with the third step, doing something about it, there are many who try to cloud the issue and keep the first question alive and kicking for as long as possible, or claim the cause is from natural forces that we can do nothing about.

The inequality debate appears to be unfolding similarly with those who would like to avoid policies to address inequality, policies such as more progressive taxation, hoping to keep the first question open as long as possible or claiming that the rise in inequality is the inevitable result of natural market forces and we should not interfere.

There is a role for skeptics, but there is also a time to accept that the preponderance of evidence points in one direction and to begin to think about and implement corrective measures.

The theories that global temperatures may be rising, and that income inequality may be getting worse, both now really seem to have an overwhelming preponderance of evidence, accumulated over many years of rigorous research, to support them. Just as importantly, in both cases there is a complete absence of recent, credible, peer-reviewed evidence suggesting that those two problems do not exist. The volume of supporting evidence, and the absence of contradictory evidence, suggest that it's time to conclude that both phenomena are actually happening.

But, as with global warming, the fact that income inequality is indeed extraordinarily high (and getting worse) is very inconvenient for policy-makers. The specific prescriptions that might be recommended to ameliorate the problem are not going to be easy to enact (if they were, they would already have been done, after all). But if we can at least think more about Mark's next question, we'll be heading in the right direction.

(At least now we know what Al Gore can focus on in the sequel...)

Strategy and CO2 Emission Targets

Here's an interesting move in the strategic "game" that the US and the EU are playing regarding greenhouse gas emission targets. From the AP:

BRUSSELS, Belgium - European Union environment ministers said Tuesday they would cut overall carbon dioxide emissions 20 percent from 1990 levels by the year 2020, adding that they were ready to go to 30 percent if other industrialized nations matched their efforts.

The reason I call this a "game" is because that's what economists call all sorts of strategic interactions... which is just a way of describing interactions where what one party does affects the decisions of the other party.

At any rate, I find it very interesting that the EU is willing to cut emissions by 30 percent, but only if the US does too. After all, if they really cared about the environment, wouldn't they just volunteer to cut to 30 in the first place? What's the explanation?

I think there's a pretty good one, actually. First of all, let's start with the presumption that the EU wants to curb greenhouse gas emissions. But they know that their own emissions are only part of the problem. Coupled with that is the concern that curbing CO2 emissions might be expensive, and reduce international competitiveness. So if they cut their emissions and no one else does, they have to pay a competitiveness price for their emission cuts in addition to the direct costs of curbing their emissions.

Given all of that, it's very sensible for them to propose what they did. On the one hand, their proposal provides an incentive for other countries to cut their emissions, in the same way that a matching gift during a pledge drive does. (Think "if you give right now, your gift will be matched dollar-for-dollar by a matching pledge, effectively doubling the value of your gift!")

But at the same time, their proposal makes good financial sense for the EU, because the more that other countries (e.g. the US) agree to cut emissions - and more importantly, the more they agree to pay the costs of cutting those emissions - the less the competitiveness penalty that the EU will pay for cutting their own emissions, which means that cutting emissions by any given amount is cheaper for the EU.

So all in all, I like this strategy by the EU toward cutting emissions. Of course, whether the incentive is sufficient to encourage the White House to agree to any emissions target is another question altogether...

Job Market Update, January 2007

The BLS has new data about the US job market this morning:

In January, total payroll employment increased by 111,000, to 137.3 million, seasonally adjusted. This increase followed gains of 196,000 in November and 206,000 in December (as revised). In 2006, payroll employment rose by an average of 187,000 per month. In January, employment continued to increase in some service-providing industries. In addition, construction employment was up, while manufacturing employment continued to trend down.

Taking a look at some of the other numbers describing the US job market, we find that the employment-population ratio has (at least temporarily) stabilized, after a nice improvement during 2005 and 2006.



Earnings, on the other hand, did not improve in 2006 as much for American production workers as, say, Exxon-Mobile's earnings did. In recent months the drop in gas prices has pushed real earnings noticeably higher, but those earnings are still only around 2% above where they were seven years ago.



So after accounting for consumer price inflation, the average production worker takes home about $10 more per week than he or she did in the year 2000. It's no wonder that lots of people feel that economic growth is passing them by...